Monday, December 17, 2012

The Fed rolls the dice, by Robert J. Samuelson, Commentary, Washington Post:
It was big news last week when the Federal Reserve announced that it wants to
maintain its current low-interest rate policy until unemployment, now 7.7
percent, drops to at least 6.5 percent. The Fed was correctly portrayed as
favoring job creation over fighting inflation, though it also set an inflation
target of 2.5 percent. What was missing from commentary was caution based on
history: the Fed has tried this before and failed — with disastrous
consequences.

By “this,” I mean a twin targeting of unemployment and inflation. In the 1970s,
that’s what the Fed did. Targets weren’t announced but were implicit. The Fed
pursed the then-popular goal of “full employment,” defined as a 4 percent
unemployment rate; annual inflation of 3 percent to 4 percent was deemed
acceptable. The result was economic schizophrenia. Episodes of easy credit to
cut unemployment spurred inflation... By 1980, inflation was 13 percent and
unemployment, 7 percent. ...

Today’s problem is similar. Although the Fed has learned much since the 1970s
... its economic understanding and powers are still limited. It can’t
predictably hit a given mix of unemployment and inflation. Striving to do so
risks dangerous side effects, including a future financial crisis. ...

It’s seductive to think the Fed can engineer the desired mix of unemployment and
inflation. And the motivation is powerful. About 5 million Americans have been
jobless for six months or more. The present job market represents, as Bernanke
said, “an enormous waste of human and economic potential.” But the Fed is
bumping against the limits of its powers. Are potential short-term benefits
worth the long-term risks? It’s a close call.

What does he think a dual mandate means if not the "twin targeting of unemployment and inflation"? That's not unique to the 1970s, it's essentially the Taylor rule (the Taylor principle comes into play as well, but I want to focus on something else). Anyway, he is trying to tell the story about shifting Phillips curve due to rising
inflationary expectations, but he misses a key part of the story. A popular
explanation for problems in the 1970s, one I think has a lot of veracity, is
that the Fed was shooting at the wrong unemployment target (you can find this story in most textbooks, e.g. see Mishkin's text on demand-pull inflation). The Fed was shooting at a
4 percent unemployment target, but because of a large influx of new workers from the baby
boom and women entering the workforce, the natural rate of unemployment was
actually much higher than 4 percent (new workers tend to have high frictional
unemployment rates, and there were also structural changes going on within the
economy that led to a higher natural rate of unemployment as well). All told,
it's not unreasonable to think of the natural rate had drifted as high as 7
percent, maybe even higher. It eventually came down to closer to 4 percent as
the surge of new workers ended and structural change abated somewhat, but for
awhile it was elevated above the Fed's 4 percent target. Unfortunately, the Fed
didn't not realize this.

Here's how the story goes. The Fed, seeing unemployment drifting toward its
natural rate of, say, 7 percent responded to its full employment mandate by
using more aggressive policy to create inflation. In the short-run, the policy
worked, unemployment did fall due to the inflationary surprise, but as soon as
people adjusted their inflationary expectations (and demanded higher wages,
etc.), the Phillips curve shifted and we ended up with the inflation we wanted,
but the employment gains were lost as the unemployment rate moved toward its
natural rate of 7 percent. At that point the Fed says to itself, we must not
have been aggressive enough, we need a second round of stimulus and it pumps up
the inflation rate even further. Again, this works so long as the inflation is a
surprise, unemployment falls in the short-run, but as soon as inflationary
expectations adjust once again the employment gains are eliminated, but the
inflation remains. As this continues, inflation continues to drift upward until
eventually we end up with double-digit inflation and nothing whatsoever to
show for it in terms of employment gains.

The fundamental problem here is a miscalculation of the natural rate of
the natural rate of unemployment. So the question is, has the Fed made this mistake again? Is the
natural rate of unemployment a lot higher than 6.5 percent so that shooting for
this target is likely to end up with double-digit, 1970s type inflation?

No for several reasons. First, the Fed is fully aware of this past mistake,
and many opposed more stimulus for precisely this reason (e.g. Narayana
Kockerlakoata would not support more stimulus until Bernanke convinced him in a
series of phone calls that the employment problem was largely cyclical, not
structural). If they are shooting at the wrong target, then the policy will not
work and they will not continue doing so as they did in the 1970s. They are much
more aware of the signs to look for that indicate they've made this mistake.
Second, there has been considerable effort to measure the
structural/cyclical/frictional unemployment mix for precisely this reason, and
the estimates, for the most part, point to a mostly cyclical problem. We didn't
have this type of information in the 1970s, in fact we weren't even asking this
question. We simply assumed that full employment meant 4 percent and set policy
accordingly. Finally, there is an inflation threshold of 2.5 percent, a
relatively low level of tolerance for mistakes of this type. If the Fed is wrong about the
structural rate, we'll see inflation, and if it the projected inflation rate
drifts above 2.5 percent, the program will be reversed. I have no doubt that
the Fed is serious abut pulling the plug if inflation rises above 2.5 percent. That's true even if
unemployment is still above 6.5 percent.

Samuelson can worry all he wants, he's good at playing the Very Serious
Person role (inflation is coming!, the debt will cause interest rates to spike!,
there could even be "dangerous side effects, including a future financial
crisis"!), but the Fed is not risking a repeat of the 1970s, not even close.

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Is the Fed Risking "Dangerous Side Effects"?

Robert Samuelson:

The Fed rolls the dice, by Robert J. Samuelson, Commentary, Washington Post:
It was big news last week when the Federal Reserve announced that it wants to
maintain its current low-interest rate policy until unemployment, now 7.7
percent, drops to at least 6.5 percent. The Fed was correctly portrayed as
favoring job creation over fighting inflation, though it also set an inflation
target of 2.5 percent. What was missing from commentary was caution based on
history: the Fed has tried this before and failed — with disastrous
consequences.

By “this,” I mean a twin targeting of unemployment and inflation. In the 1970s,
that’s what the Fed did. Targets weren’t announced but were implicit. The Fed
pursed the then-popular goal of “full employment,” defined as a 4 percent
unemployment rate; annual inflation of 3 percent to 4 percent was deemed
acceptable. The result was economic schizophrenia. Episodes of easy credit to
cut unemployment spurred inflation... By 1980, inflation was 13 percent and
unemployment, 7 percent. ...

Today’s problem is similar. Although the Fed has learned much since the 1970s
... its economic understanding and powers are still limited. It can’t
predictably hit a given mix of unemployment and inflation. Striving to do so
risks dangerous side effects, including a future financial crisis. ...

It’s seductive to think the Fed can engineer the desired mix of unemployment and
inflation. And the motivation is powerful. About 5 million Americans have been
jobless for six months or more. The present job market represents, as Bernanke
said, “an enormous waste of human and economic potential.” But the Fed is
bumping against the limits of its powers. Are potential short-term benefits
worth the long-term risks? It’s a close call.

What does he think a dual mandate means if not the "twin targeting of unemployment and inflation"? That's not unique to the 1970s, it's essentially the Taylor rule (the Taylor principle comes into play as well, but I want to focus on something else). Anyway, he is trying to tell the story about shifting Phillips curve due to rising
inflationary expectations, but he misses a key part of the story. A popular
explanation for problems in the 1970s, one I think has a lot of veracity, is
that the Fed was shooting at the wrong unemployment target (you can find this story in most textbooks, e.g. see Mishkin's text on demand-pull inflation). The Fed was shooting at a
4 percent unemployment target, but because of a large influx of new workers from the baby
boom and women entering the workforce, the natural rate of unemployment was
actually much higher than 4 percent (new workers tend to have high frictional
unemployment rates, and there were also structural changes going on within the
economy that led to a higher natural rate of unemployment as well). All told,
it's not unreasonable to think of the natural rate had drifted as high as 7
percent, maybe even higher. It eventually came down to closer to 4 percent as
the surge of new workers ended and structural change abated somewhat, but for
awhile it was elevated above the Fed's 4 percent target. Unfortunately, the Fed
didn't not realize this.

Here's how the story goes. The Fed, seeing unemployment drifting toward its
natural rate of, say, 7 percent responded to its full employment mandate by
using more aggressive policy to create inflation. In the short-run, the policy
worked, unemployment did fall due to the inflationary surprise, but as soon as
people adjusted their inflationary expectations (and demanded higher wages,
etc.), the Phillips curve shifted and we ended up with the inflation we wanted,
but the employment gains were lost as the unemployment rate moved toward its
natural rate of 7 percent. At that point the Fed says to itself, we must not
have been aggressive enough, we need a second round of stimulus and it pumps up
the inflation rate even further. Again, this works so long as the inflation is a
surprise, unemployment falls in the short-run, but as soon as inflationary
expectations adjust once again the employment gains are eliminated, but the
inflation remains. As this continues, inflation continues to drift upward until
eventually we end up with double-digit inflation and nothing whatsoever to
show for it in terms of employment gains.

The fundamental problem here is a miscalculation of the natural rate of
the natural rate of unemployment. So the question is, has the Fed made this mistake again? Is the
natural rate of unemployment a lot higher than 6.5 percent so that shooting for
this target is likely to end up with double-digit, 1970s type inflation?

No for several reasons. First, the Fed is fully aware of this past mistake,
and many opposed more stimulus for precisely this reason (e.g. Narayana
Kockerlakoata would not support more stimulus until Bernanke convinced him in a
series of phone calls that the employment problem was largely cyclical, not
structural). If they are shooting at the wrong target, then the policy will not
work and they will not continue doing so as they did in the 1970s. They are much
more aware of the signs to look for that indicate they've made this mistake.
Second, there has been considerable effort to measure the
structural/cyclical/frictional unemployment mix for precisely this reason, and
the estimates, for the most part, point to a mostly cyclical problem. We didn't
have this type of information in the 1970s, in fact we weren't even asking this
question. We simply assumed that full employment meant 4 percent and set policy
accordingly. Finally, there is an inflation threshold of 2.5 percent, a
relatively low level of tolerance for mistakes of this type. If the Fed is wrong about the
structural rate, we'll see inflation, and if it the projected inflation rate
drifts above 2.5 percent, the program will be reversed. I have no doubt that
the Fed is serious abut pulling the plug if inflation rises above 2.5 percent. That's true even if
unemployment is still above 6.5 percent.

Samuelson can worry all he wants, he's good at playing the Very Serious
Person role (inflation is coming!, the debt will cause interest rates to spike!,
there could even be "dangerous side effects, including a future financial
crisis"!), but the Fed is not risking a repeat of the 1970s, not even close.